Professional Documents
Culture Documents
KingSaudUniversity
CBAFinanceDepartment
Summary of
Preparedby:MohammedAlhassan
Copyright2014,AllRightsReserved
Probability
Events
0.80
E1
0.20
E2
E3
P i
...
.
Almarai
Comparison between the fluctuation of the stock price of Almarai and Salama
Comments:
1. These graphs represent the evolution over time for two stocks listed on Tadawl.
2. Historical data was extracted from Tadawl and during the perios (2012-2014, daily
price).
3
3. we notice a linear tendency for Almarai stock operating in the Retail sector.
4. Almarai stock is increasing during the whole period, however, Salama stock price
seems to be more volatile. because of its high fluctuation during the same period
so risk is higher for Salama
5. we expect a negative correlation (co-movement) between the two stocks.
6. having a negative correlation between the stocks will be useful for portfolio
management.
7. in fact, selecting these two stocks reduces the level of portfolio risk. Diversification
benefit in.
8. we expect negative correlation between the two stocks because we have two
firms operating in two different sectors.
Ri =
(P 1 P 0)+D1
P0
Rrajhi =
(78 74)+2.55
74
= 0.0885 or 8.85%
4
E(R i)=theexpectedreturn
E (Ri) = P i Ri
Pi=theprobabilitywemusthave = P i = 1
i=1
i=1
stock price
probabilities for next
week
75
0.2
70
0.1
73
0.4
78
0.2
78
0.1
total
Stock Return
Expected return
Ri
E (Ri)
75 70
70
= 7.14%
70 70
70
0.01428
= 0%
= 4.28%
0.01712
78 70
70
= 11.42%
0.02284
78 70
70
= 11.42%
0.01142
73 70
70
0.06566or6.56%
E (Ri) = Ri
E(R i)=theexpectedreturn
n=numberofprices
i=1
months
closing price
last few months
Dividends
Stock Return
Expected return
Ri
E (Ri)
115
(115 100)+3
100
= 18%
110
(110 100)+3
100
= 13%
90
(90 100)+3
100
100
(100 100)+4
100
= 4%
105
(105 100)+5
100
= 10%
total
7%
38%
38%
5
= 7.6%
*
%20= n1
E (Ri) = P i Ri
i=1
E (Ri) =
i=1
1
n
Ri
P i
E (Ri) =
i=1
Ri
n
= n1
2 (Ri) = P i(Ri
E (Ri) 2
i=1
6
2 (Ri)
=
i=1
(Ri E(Ri) 2
n
i=1
i=1
(Ri) ,
2
Almarai
0 , and 0
i.e continued:
months
Stock Return
Ri - E(Ri)
Ri
(Ri
E (Ri)) 2
*variance
18%
18%7.6%=10.4%
0.010816
13%
13%7.6%=5.4%
0.002916
7%
07%7.6%=14.6%
0.021316
4%
4%7.6%=3.6%
0.001296
10%
10%7.6%=2.4%
0.000576
total
2 (Ri) =
(Ri) =
0.03692
5
0.03692or3.692%
= 0.007384 or .7384%
(Ri) = 0.007384 =
2
0.085 or 8.59 %
The expected monthly return equal 7.6% however the standard deviation equal 8.59%
its higher than average return.
4.3) In order to have an idea about the amount of risk (S.D) relative to the average return
we calculate the coefficient of variance
CV =
CV =
(Ri)
E(Ri)
(Ri)
E(Ri)
=
8.59%
7.6%
= 113%
compare to the expected return, risk measured by the standard deviation is high.
Therefore, it will not be useful for investors to include this stock in their portfolio
because its high level of risk.
*If investors are looking for low level of risk they should select stock with lower CV.
*Looking for higher risk higher CV.
8
4.4.1) covariance
-
E (Ra))(Rb
E (Rb))
i=1
-
cov(Ra, Rb) =
i=1
a b
4.4.2) correlation
its very important to estimate the correlation when we select stocks.
lets consider two stocks (A) and (B)
corr(Ra, Rb) =
cov(Ra,Rb)
(a b)
*The Correlation and Covariance have the same SIGN but different VALUES
1 corr(Ra, Rb) 1
if corr(Ra,Rb) = -1 stocks (A) & (B) are negatively correlated and perfectly correlated.
if Ra = 10%
Rb =
10%
if corr(Ra,Rb) = 1 stocks (A) & (B) are positively correlated and perfectly correlated.
if Ra = 10%
Rb = 10%
if corr(Ra,Rb) = 0
Cov=0 NO relationship
X is a random variable
E (a. X) = P i(aX) = a
i=1
Pi X
so.
E (a. X) = a . E(X)
E (ax + by) = a . E(x) + b . E(y)
Application: Lets consider a portfolio containing two stocks A and B with the following:
E(Ra) = Ea = 10%
E(Rb) = Eb = 14%
Wa= 0.6
Wb= 0.4
(0.6
10%) + (0.4
2 (a. x) = a2 . 2 (x)
2 (ax + bx) = a2 . 2 (x) + b2 . 2 (y) + 2ab.cov(x, y )
C orr(x, y ) =
Cov(x,y)
xy
11
0.6)(0.02)(0.04)
(Rp) =1.3%
Expected Return
S.D
CV= E
Stock A
10%
2%
0.20
Stock B
14%
4%
0.29
11.6%
1.3%
0.11
Portfolios
Diversification is very useful because the portfolio has lowest coefficient of variance CV
a2
1-
b2
2ab
corr(a, b)
*
12
2W aW b.a.b
(a b) 2 = a2 + b2 2ab
(a + b) 2 = a2 + b2 + 2ab
1
W a2 . 2 (a)
2
2
b2 = W b . (b)
2ab = 2W aW b.a.b
a2 =
= [W a . (a)
W b . (b)] = 0 W aa
W bb = 0
Wa + Wb = 1 Wb = 1 Wa
W aa (1 W a)b = 0 W aa b + W ab = 0 W a(a + b)
3.5%
b
= 0.63 or 63%
W a = a+b
= 2%+3.5%
Wb = 1
b = 0
0.63 = .37
Risk = 0
13
b2
a2
1-
2ab
corr(a, b)
(a + b) 2 = a2 + b2 + 2ab
W a . (a)
2
2
b2 = W b . (b)
2ab = 2W aW b.a.b
a2 =
:
2
= [W a . (a) + W b . (b)] = 0 W aa + W bb = 0
Wa + Wb = 1
W aa + (1
Wb = 1
Wa
W a)b = 0 W aa + b W ab = 0 W a(a
= a bb = 2%3.5%
3.5% = 2.33 or 233%
Wa
Wb = 1
2.33 = 1.33 OR
b) + b = 0
133%
Risk = 0
14
1-
(a
2 (Rp) = W a2 . 2 (a) + (1
W a2 (a)2 + [1 2W a + W a2 ]
b) 2 = a2 + b2
2ab
W a).cov(a, b)
2W a 1 cov(a, b) and 2W a
W a cov(a, b)
2
2
2
2
W a2 (a)2 + (b) 2W a(b) + W a (b) + 2W a.cov(a, b) 2W a2 .cov(a, b)
common f actor W a2 [(a)2 + (b)2 2.cov(a, b)] + W a [ 2(b)2 + 2.cov(a, b)] + (b)2
:
W a2 .A + W b.B + C
2Wa.A+B+0
:
A= [(a) + (b)
2.cov(a, b)]
2
B= [ 2(b) + 2.cov(a, b)]
C= (b)2
2
2
2
2.cov(a, b)] + [ 2(b)2 + 2.cov(a, b)] = 0
W
a = 2W a [(a) + (b)
2W a [(a)2 + (b)2 2.cov(a, b)] = [2(b)2 2.cov(a, b)]
2((b) .cov(a,b))
(b) .cov(a,b)
W a = 2[(a)2(b)+(b)2.cov(a,b)
2.cov(a,b)] 2((a) +(b) 2.cov(a,b)) (a) +(b) 2.cov(a,b)
2
Wa =
(5%)2 0.6
(2%)2 +(5%)2 2(0.6)
= 0.50 W b = 0.50
15
Wa =
2b Cov(A,B)
2a + 2b 2Cov(A,B)
We can find the optimal weight *Wa and *Wb using correlation
cov(Ra, Rb) = corr(Ra, Rb) a b
Wa =
2b Corr(A,B). a . b
2a + 2b 2Corr(A,B). a . b
calculate or compute
16
lets assume that we have to stocks A and B with Ea and Eb, the expected returns and
this is Equation 1
corr(a, b)
= [W a . (a) + W b . (b)] = 0 W aa + W bb = 0
Wa + Wb = 1
Wb = 1
Wa
17
W aa + (1
Wa =
W a)b = 0 W aa + b
p b
a b
W ab = 0 W a(a
b) + b = p Equation 2
p b
Ep= a b (Ea-Eb)+Eb
Eb
Eb
Ep= p ( Ea
) - b ( Ea
)+Eb
a b
a b
Ep= p A-B
Y=ax+b <<
a=
x=
b=
Equation 3
When the two stocks A and B are perfectly and positively correlated, all the
possible portfolios containing A and B will be exactly on the straight line [AB].
For all these possible portfolios, we find a positive and linear relationship
between expected return (Ep) of the portfolios and its level of risk (Op).
Eb
Eb
Ep= p ( Ea
) - b ( Ea
)+Eb
a b
a b
B
18
When the correlation between the two stocks A and B is different from (+1), all
the possible portfolios will be located on the curve joining the two points A and B
When the correlation is low, the curve should move to the left because risk of the
portfolios will be reduced.
We find a quadratic and positive relationship between portfolio expected return
(Ep) and its level of risk (Op).
19
1. The efficient frontier is a curve joining all the possible and efficient portfolios.
2. The efficient frontier makes the separation between possible and inefficient
portfolios and possible and efficient portfolios.
20
E (a) = 10%
E (b) = 12%
,
,
(a) = 3%
(b) = 5%
Corr(A,B) = 0.6
How we can draw the efficient frontier for portfolio of 2 stocks A and B?
Wa
Wb
0.9
0.1
0.8
0.2
0.7
0.3
E(p)
(p)
after distributing the weights and solving the expected return and risk for the portfolio
youll have a number of portfolios and an efficient frontier.
21
E p = W a E a + W rf r RF R and we know W a + W rf r = 1 W rf r = 1 W a
E p = W a E a + (1 W a) RF R E p = W a(Ea RF R) + RF R Eq.1
2 p = W a2 a2 + W rf r2 rf r2 + 2W aW rf r C orr(A, RF R) a b
W rf r2 rf r2 =0
2W aW rf r C orr(A, RF R) a b =0
Ep =
p
a
[Ea
RF R] + RF R E p = RF R +
Ea RF R
a
Y = A+BX :
Ea RF R
a
Ea RF R
a
The risk premium is the compensation against risk when investors select risky assets.
The risk premium is positively correlated to the degree of risk aversion.
Risk Aversion Risk Premium
5. We can say that the CML is the NEW EFFICIENT FRONTIER representing efficient
portfolios containing both stocks and bonds. this new efficient frontier is linear
and positive
(Z) is an impossible portfolio when investing only in stocks because (Z) is above the
curve(Efficient frontier). However, using stocks and bonds, (Z) is a possible portfolio, but
inefficient. We can find another portfolio (Z1) better than (Z).
Z1>Z because z1 = z and Ez1 > E z .
Therefore, all the Efficient portfolios of stocks and bonds are exactly located on the
straight line (CML).
23
CML: E p = RF R +
Ea RF R
a
for a portfolio A.
E p = RF R +
Em RF R
m
7. According to the CML, the expected return is the sum of two parts:
Part1: RFR: Fixed return on T.Bills (Bonds)
Part2: Risk Price Em RF R adjusted (multiplied) by the level of risk (measured by S.D).
m
24
Em RF R
m
CML is the New Efficient frontier for portfolio containing stocks and bonds.
Portfolio (Z) is a possible and efficient because its located on the CML.
The main feature of the CML is to allow for the leverage effect. Its possible to
borrow money (short position on bonds) in order to invest more in the market
portfolio. Therefore, investor profit from borrowing money to have portfolios with
highest expected return and risk than the market.
Example: The initial investment is 1M. (Wm=1.8 and Wrfr=-0.8)=portfolio Z, We
invest 1.8M in the Market portfolio. We borrow 0.8M (we are shorting on 0.8M
bonds).
25
a = 3%
b = 6%
corr(A,B) =0.6
Wa=0.5, Wb=0.5
E p = RF R +
Em RF R
m
we must find Em
Em = WaEa+WbEb= 13.5%
2p = 2m = W a2 a2 + W b2 b2 + 2W aW bCorr(A, B )ab =0.13%
2p = 2m
26
E (Ri) = RF R +
Em RF R
2m
Cov(Ri, Rm )
E (Ri) = RF R +
Em RF R
2m
Cov(Ri, Rm )
E (Ri) = RF R + [Em
RF R]
Cov(Ri, Rm )
2m
Cov(Ri, Rm )
2m
< Beta
(investopediadefinition):Betaisameasureofthevolatility,orsystematicrisk,ofa
securityoraportfolioincomparisontothemarketasawhole.
27
C orr(Ri, Rm) =
Cov(Ri, Rm )
m i
Corr(Ri,Rm)( m )( i )
m m
Corr(Ri,Rm)( i )
m
(x xbar)(x xbar)
n
Cov(Rp, Rm )
2m
=
2
m
2m
= 2x
=1
Form
Relationship
Sign of the slope
Slope
Risk
CML
SML
Linear
Linear
Em RF R
m
>0
Em RF R
2m
>0
Cov(Rp,Rm)
Allows for
Leverage effect
No leverage effect
Portfolio
Stocks+Bonds
Stocks+Bonds
Graph
28
y = a + bx + t
Ri = a + (Rm) + i
y = 0.0036 1.34(Rm)
(x x)(y y)
b=
(x x)
b=
(x x)(y y)
n
(x x)2
b=
Cov(Rm ,Ri )
( m )2
= <<Beta!
29
Cov(Rm ,Ri )
Corr(Rm ,Ri )( i )
or
m
( m )2
2 (Ri ) = i2 . 2m + 2 (i )
30
Syst.Risk
T otal Risk
2i 2m
2i
U nsyst.risk
T otal risk
2 (i )
2i
(W1=W2=....Wn)(n Stocks)
Rp = W 1 R1 + W 2 R2 + ... + W n Rn
= (W 1 1 + W 2 2 + ... + W n n ) + (W 1 1 Rm + W 2 2 Rm + ... + W n n Rm)
+ (W 1 1 + W 2 2 + ... + W n n )
(W 1 1 + W 2 2 + ... + W n n ) = p
(W 1 1 + W 2 2 + ... + W n n ) = p
Rp = p + Rm (W 1 1 + W 2 2 + ... + W n n ) + p
unsystematic risk =
2 (p ) = 2 (W 1 1 + W 2 2 + ... + W n n )
= ( 1n )2
n
1 2
[2 (1 ) + 2 (2 ) + ...2 (n )] = ( n )
1
n
closer to 0,
( 1n )L
2 (i )
i=1
more closer to 0 2 (p )
We show that for fully diversified portfolio the unsystematic risk will be reduced to Zero.
as its shown in the graphs. (Reducing specific risk for fully diversified portfolio)
31
E (Ri) = RF R + [E m
RF R] i
According to the CAPM, The expected return is the sum of two parts:
Part 1: Risk free rate = interest rate on T.Bills
Part 2: is the risk premium adjusted (multiplied) by beta.
32
33
T =
Ri RF R
i
Ri: The average rate of return for a portfolio using a given holding period.
RFR: The average of the RFR using the same period.
Bi: Portfolio i's beta
R
T m = Rm mRF
Risk P remium
=1
TS > TM
RpAverageAnnualReturn
Beta
ManagerW
12%
0.9
ManagerX
16%
1.05
ManagerY
18%
1.20
34
Ri RF R
i
Ri: The average rate of return for a portfolio (i) using a given holding period.
RFR: The average of the RFR using the same period.
i : the standard deviation of the rate of return using the same period.
Si: Risk Premium return earned per unit of total risk
Si =
Application:RFR=7%
PF
Return
Beta
Sp
Tp
Rank S
Rank T
0.15
0.05
1.6
0.08
0.20
1.5
0.10
1.3
0.0866
0.10
0.6
0.03
0.05
0.17
1.1
0.06
1.666
0.09
Market
0.13
0.04
1.5
0.06
35